5 years after Lehman, how safe is your bank?

Five years after Lehman Brothers collapsed and AIG (AIG) got bailed out, regulators insist that the banking system is safer, taxpayers are protected from being asked to rescue Wall Street again, and the next panic will be more orderly.

Critics contend that the banks are bigger now, that the landmark Dodd-Frank financial reform act is an unfinished labyrinth of overly burdensome regulations and that "Too Big to Fail" remains a troubling reality of the financial system.

Who's right?

Here's a look at what's happened, what hasn't happened, and what it means for the next crisis.

A wider safety net

There's little debate that banks have more capital and greater liquidity, that is, they have a bigger cushion to ward off the next panic. Capital ratios for the nation's 18 biggest banks are up by $450 billion since 2008, according to the Treasury Department. The ratio of capital to assets is up to 12 percent on average from around 8 percent in 2008.

The Federal Reserve has also instituted, as mandated by Dodd-Frank, routine annual stress tests that limit how much a bank can spend on dividends and share buyback programs and test for whether a bank is capable of withstanding a severe financial shock. Under recent stress scenarios, the biggest banks would now have more capital than they had during good times before the crisis.

There's also little doubt that tougher financial regulations now cover more of the banking systems. Twelve new banks will be forced to undergo stress tests next year and two companies-AIG and General Electric Capital (Grey Market: GEAPO)-will be subject to financial supervision similar to banks.

All of these big institutions are required now to maintain up-to-date living wills-a blueprint for unwinding the bank in the event of a crisis. This should help avoid the chaos of the Lehman weekend five years ago when regulators struggled to understand the dimension of the bank's complex derivative holdings and its ties to other financial firms.

'Title II' bankruptcy

Finally, inside Dodd-Frank is what one securities attorney calls "the single best part of the financial reform act." It's known as Title II, or in layman's terms, bankruptcy for banks. (Since it is not part of the bankruptcy law, it is technically inaccurate to call it bankruptcy or, as some put it, Chapter II bankruptcy. It's not.)

It's a step-by-step process that governs what happens the next time a big financial institution teeters and falls. It calls for management to be removed, the bank holding company to be place into receivership, its subsidiaries to be placed into a bridge company that is financed by the Federal Deposit Insurance Corp. Stockholders would be wiped out and debt holders would bear losses. The FDIC would temporarily finance the bridge company but the law allows the government to turn to debt holders to recover any losses from a Title II resolution. If that is insufficient, it has the right to ask for repayment from the financial industry.

Regulators insist this should ensure that taxpayers are not put on the hook again.

The criticisms of the new rules run the gamut from conservative to liberal, from those who believe the government has done either too much or too little, and those who believe the government has squarely addressed the wrong problems.

Among those who think the government has done too much are two very different ideas: One group says the 13,000 pages of new rules (nearly 15 million words, according to the Hamilton Project) overlays a costly regulatory burden on the financial industry that hampers its ability to provide credit for the economy to grow. They say it's a big reason for low economic growth right now.

Yet another viewpoint comes from those who say the new rules have done too much to hamper government the next time there is a crisis. In other words, they argue that Dodd-Frank and other rules make a mistake by making it too difficult for the government to bail out a bank again.

For example, Dodd-Frank prohibits the Federal Reserve from using its emergency powers to bail out an individual bank as it did with AIG and Bear Stearns. It can still provide broad-based, industrywide support through its special authority, but it now requires approval of the Treasury secretary. Given the political fallout from the financial crisis, that approval is not assured.

Bigger hurdle for bailouts

Finally, separate legislation prohibits the use of the Economic Stabilization Fund to bail out financial institutions. The fund was used during the financial crisis to backstop the money market industry.

While some argue that the president, faced with a financial crisis, can find a pot of money somewhere to bail out a bank, government officials say, that will be very difficult next time. They point to the use of the obscure stabilization fund-originally meant for currency intervention-as an example of how hard it is to find funding for a bank bailout. Since only the Fed can create money-and the Fed can no longer bailout a bank-the next financial rescue will almost certainly require congressional funding and approval. The concern is that the approval could come too late to stave off broader financial panic, if it comes at all.

Supporters of this arrangement look at this very criticism and declare victory: They say making government bailouts difficult or even impossible is exactly the right goal. If that belief permeates markets, then it is believed that investors will make smarter decisions, charge banks more for their debt and capital and keep down leverage. A measure of success is seen in bond spreads. The Hamilton Project says that big banks now pay more to fund their debt than smaller banks, a reversal from before the crisis and a sign that lenders believe at least somewhat less in a government bailout.

But concern over "Too Big to Fail" is why Dodd-Frank critics bristle at the part of Title II that allows the FDIC to finance the newly formed bridge company. They say that institutionalizes a government bailout mechanism, even though that mechanism will not be funded by taxpayers.

Long way from the finish line

Other Dodd-Frank criticisms concern the delay in implementation. The law firm Davis-Polk estimates that only a third of the required rules have yet to be proposed or finalized. Only 40 percent have been both proposed and finalized. The Treasury Department counters that 23 percent of the rules have not been proposed or finalized and says it is much more interested in adopting quality laws than it is in getting them done quickly. Still, Treasury Secretary Jack Lew threw down the gauntlet in a July CNBC interview, saying he wants the major parts of Dodd-Frank done by year-end. Only then does he see a need to revisit the law and whether it does indeed address Too Big to Fail.

Among the missing rules are those governing derivatives and the infamous Volcker Rule , which, when complete, will prohibit banks from proprietary trading, or trading for their own account. Even the much-touted Title II legislation is not complete. According to Davis-Polk, only six of 21 rules for winding down big banks in bankruptcy have been finalized.

A curious marriage of critics from the left and right say Dodd-Frank will never be enough and urge the government to go well beyond the Volcker Rule. Democratic Sen. Elizabeth Warren joined with GOP Sen. John McCain to introduce legislation to bring back Glass-Steagall, the Depression-era law that separates banking and investment banking.

But what about short-term funding?

One other criticism, which actually comes from the Federal Reserve, is that regulation has so far not addressed what many consider to be one of the root causes of the crisis: short-term funding. Many see the financial crisis in 2008 as a run on the overnight short-term funding system. It was the same as a classic bank run, but instead of depositors lining up outside banks, banks lined up to get back money they had loaned overnight to other banks. The size of this market has been reduced but still remains substantial. Among the concerns is the ability of money markets, which supply a lot of the short-term funding to the financial system, to maintain $1 share prices even though the underlying collateral of the fund may have declined.

Two other areas of criticism are worth noting. The first is the critique that the real problem had little to do with banking excesses or the lack of regulation but with government policies, both from the Fed, Congress and successive administrations. These policies, such as those that promoted home ownership, distorted private sector decisions and led to asset bubbles and busts. In this view, the massive Dodd-Frank law is a mostly unnecessary exercise. The key to avoiding the next panic will be getting Fed policy right and avoiding legislative distortions that prompt the market to excesses. The failure to reform Fannie Mae and Freddie Mac stands out to this group as a major failure of post-crisis regulation.

The song of the sirens

The last area of concern is the unknown: Some of the new laws rely on tried-and-true concepts, such as higher capital and lower leverage ratios. But other parts of Dodd-Frank, such as living wills and Title II, have never been tried and the great hope is they will never be battle-tested.

More significant is what economists and regulators call the "time consistency problem." It boils down to this: When the next boom happens, will they follow through on their promises to keep the brakes on the financial system? It's called a Ulysses Pact-after the Greek hero who wanted to hear the song of the Sirens and had himself tied to the mast so he wouldn't jump off the ship and join them. The worry is that the next time the financial markets sing the siren song of economic prosperity, political pressures will untie the regulations and the system will face another cycle of irrational booms and busts.